Case of the Day: Mortgage-Backed Securities and the Allocation of Risk
Traditional mortgage markets
A mortgage is a loan that finances the purchase of real estate. There are both commercial and residential mortgages, but we shall focus on the latter. Mortgages are long-term loans, usually repaid in monthly payments over 15, 20 or 30 years, and are secured by a lien on the property being purchased. Traditional mortgages carry a fixed interest rate and a constant nominal monthly payment. If the borrower fails to make the required payments, they are in default and the lender may foreclose on the mortgage and take legal possession of the property.
For the first three decades after World War II, residential mortgage lending in the United States was dominated by savings-and-loan associations and mutual savings banks (collectively called "thrifts"), along with commercial banks and credit unions. Thrifts were specialized financial intermediaries (often owned by their depositors) that accepted non-checkable savings deposits from customers and issued mortgages to buyers of residential real estate. (A useful history of the thrift industry is provided by David Mason on the Economic History Association's EHNet. Read it if you want more information.)
In the simplest transaction, a thrift would use its depositors' money to make a mortgage loan, on which it would then collect payments over 30 years until the mortgage was retired. Because the deposits that are used to make the mortgage loan are short-term in nature—they can be withdrawn immediately or on short notice—the thrift is in an extreme position of "borrowing short and lending long," which to some degree is typical of most depository intermediaries. As long as interest rates and the supply of deposits to the thrift are stable, the institution can continue to thrive, collecting interest and principal payments from its mortgage customers and using the proceeds to make new loans and to pay interest to its depositors.
Liquidity issues and secondary markets
However, this extreme liquidity imbalance between its assets and liabilities puts the mortgage lender in a potentially precarious position in either of two situations: if interest rates rise or if depositors withdraw large amounts of funds.
If interest rates rise rapidly (as they did in the 1970s), the thrifts will have to raise the interest rate they pay on its deposits in order to remain competitive. (Failing to do so would cause depositors to withdraw funds, discussed below.) If the interest rate on its mortgages is fixed, this may put the institution into a loss-making situation, where it is paying a higher interest rate on deposits than it receives on its loans. Savings-and-loan associations faced a crisis in the 1970s as inflation drove short-term deposit interest rates upward while the institutions' mortgage assets paid the very low rates that had been set in the 1950s and '60s. Many thrifts went out of business during this period, particularly in the 1980s in the Southwest region, where a rapid decline in property values led to widespread defaults. As a result of this adverse movement in interest rates, mortgages with adjustable interest rates became common. The interest rates on these loans float upward and downward (usually within a limited range) with movements in some key shorter-term market interest rate such as the prime rate.
If depositors decide to withdraw their funds from thrifts, the illiquidity of the thrifts' asset portfolio can become a problem. If the stream of monthly payments (together with the reserves held) does not generate a large enough flow of cash to pay off the expanding stream of withdrawals, then the thrift faces a liquidity crisis. It cannot legally demand early repayment of mortgages, so it must seek cash from another source.
Recognizing that thrifts, both individually and collectively, would need access to liquidity from time to time, the federal government established federal institutions to facilitate a secondary market on which thrifts (and other mortgage lenders) could sell their mortgages in order to get cash when they needed liquidity. These institutions evolved into three organizations: Federal National Mortgage Association (FNMA, or Fannie Mae), Government National Mortgage Association (GNMA, or Ginny Mae), and Federal Home Loan Mortgage Corporation (FHLMC or Freddie Mac). The differences among these institutions are not important for this case. They all served to provide liquidity to mortgage issuers by purchasing mortgages from them and bundling them into "mortgage-backed securities," bonds that are backed by the purchased mortgages and sold to institutional investors and the general public.
So if an S&L wanted to make its portfolio more liquid, it could sell some mortgages to one of the government institutions, say FNMA, which would, in turn, issue long-term bonds to financial investors in order to raise the money to buy the mortgages. The S&L would continue to collect monthly payments from the borrower and would pass along the stream of payments to FNMA. As long as the mortgages continued to be repaid as planned, everyone was happy. FNMA was profitable because the stream of payments coming in from the mortgages were sufficient pay the interest and principal on the long-term bonds they issued. The investors who held the bonds were happy because they received the interest payments on their bonds. The S&L was content because it had acquired the liquid assets that it needed when it sold the mortgages. When all goes well, mortgage-backed securities (MBSs) such as those issued by FNMA are a win-win-win situation.
FNMA and its siblings recognized that the financial institutions knew their borrowers much better than FNMA possibly could. Indeed, this is one of the key roles played by banks and thrifts in our economy: collecting and using financial information about their customers. With this asymmetry of information, FNMA could have suffered from adverse selection if banks and thrifts chose to sell their risky mortgages to FNMA and keep the safe ones for themselves. To prevent this, FNMA and the other institutions established risk guidelines for the "conforming" mortgages they would buy. These typically set minimum standards for the loan/value ratio (for example, only mortgages of up to 80% or 90% of the assessed value of the collateral property) so that there would be a cushion of extra money to pay for foreclosure costs in case of default and to provide a buffer against possible declines in real-estate prices. They also often required that the borrowers have good credit ratings and set limits on the amounts and terms of the mortgages.
This "securitization" of mortgages worked effectively for several decades, providing liquidity to mortgage lenders and opportunities for long-term investors. However, not everyone qualified for conforming loans that could be sold on to FNMA et al. Of course, borrowers whose mortgages could not be re-sold were much less attractive to lenders and were often precluded from getting loans. These borrowers tended to be less wealthy and were often members of minority groups. Policymakers who wanted improved access to housing for these people pushed the government mortgage associations to offer securities backed by "subprime" loans—those with characteristics that failed to meet the traditional guidelines. There was also competition from "private-label" MBSs issued by non-governmental financial institutions, sometimes including the banks or thrifts that were making the loans in the first place.
The widespread availability of MBS funding meant that an institution could make martgage loans even if it didn't have a base of deposits. Instead of obtaining the money to lend from depositors, new specialty mortgage lenders and "mortgage originators" emerged who simply issued mortgages and sold them to investors through MBSs. These institutions would often hold a given mortgage no more than a few days before selling it on in the secondary market.
As mortgage lenders began to be able to sell non-conforming loans through MBSs, it became convenient for them to increase the volume of mortgages dramatically without worrying too much about the quality of the borrower. The banks and other mortgage originators were not planning to hold the loans on their books anyway, so defaults would be someone else's problem. In the meantime, they would pocket loan origination fees and other closing costs (regardless of whether the loan would end up being repaid or not) and earn additional servicing fees for managing the payments when they came in. Buyers of subprime MBSs knew that the loans backing their bonds were of less than high quality, but they didn't know exactly how bad they were.
Peter Goodman and Gretchen Morgenson of the New York Times detailed the lending practices of Washington Mutual, one of the most aggressive subprime lenders, in an article that you should read, published on December 28. 2008. This article gives a good view of the mind-set of subprime lenders during the boom years.
This explosion in lending fueled a dramatic surge in housing demand, leading to a boom in the construction industry. Predictably, many of the subprime borrowers turned out not to be able to make their mortgage payments. The perfect storm arrived in 2008 when, simultaneously, defaults on mortgages began to rise, worried buyers started trying to sell their homes, and the construction boom had built tens of thousands of homes based on the speculation that the subprime-led buying spree would continue. The resulting excess supply of housing burst the bubble of home prices and sent them downward at an unprecedented pace.
The decline in housing prices, of course, lowered the collateral value of the houses backing the mortgages, meaning that even if banks foreclosed on the houses they might end up taking large losses. And mortgage defaults continued to climb as more and more borrowers found themselves "under water"—owing more on their mortgage than their houses were worth.
The banks were hit hard, and to the extent that they had offloaded their mortgage debt to others through MBSs, the problem spread through the entire financial system. Any financial firm (insurance company, pension fund, brokerage firm, investment bank, hedge fund, etc.) with a large exposure to MBSs was vulnerable.
Compounding the problem: CDOs and CDSs
We've seen that mortgage-backed securities can be wonderfully useful in allocating risk and liquidity to those who are want or need it. In general, this is what financial markets do: they allow individuals who are willing to bear it to acquire risk from those who are not, and individuals who need liquidity to obtain if from those who don't. However, each stage by which we separate the ultimate investor from the ultimate borrower dilutes the flow of information about the quality of the loan and the likelihood of repayment.
And by the mid-2000s there were several more layers added on top of the mortgage-backed securities themselves.
Financial derivatives are synthetic assets whose value is based in the value of some other underlying asset. MBSs are a simple form of derivative based on the mortgages themselves. Other common derivatives are futures contracts (in which two parties agree to exchange an asset at a specified future date and price) and options (in which one party purchases the right but not the obligation to buy or sell an asset from someone else at a given future date and price). Futures, options, and other more complicated derivatives allow investors to "bet" on future movements in the price of the underlying security. Although betting is usually associated with taking on additional risk, derivatives are often used to reduce risk. For example, someone scheduled to receive a payment in euros in January can reduce risk by arranging a futures contract now to exchange the euros into dollars at today's futures price.
Derivatives allow the risk of an asset to be traded independently of the asset itself; you can bet on the future price of Microsoft stock through derivatives without owning any actual shares. Several new kinds of derivatives have emerged in recent decades that were related to MBSs. Collateralized debt obligations (CDOs) are securities backed by other securities, but with varying priority of repayment. For example, one might slice up the rights to a given pool of MBSs. At one end of the spectrum are safe CDOs that are repaid first: they get the highest priority for repayment out of the returns on the underlying MBSs. At the other end are very risky CDOs (sometimes colloquially called "toxic waste") that are repaid with lowest priority. Any losses on the underlying securities (MBSs) are taken first out of the return to the riskiest tier of CDOs. Then, if the risky tier is wiped out and there are still additional losses, the next risky tier takes a hit, and so on. The safest tier of CDOs is effectively insured by the presence of the riskier tiers that will absorb losses first. Only if the entire pool of MBSs turns out to be totally worthless will the safest tier CDOs suffer losses. Someone with a high tolerance for risk can potentially earn a high return by buying the less desirable risky CDOs at low prices and hoping that there are no defaults. More risk-averse investors can buy CDOs from the safe end of the spectrum and get full repayment unless a severe catastrophe wipes out most of the value of the MBSs.
Even pools of CDOs can be broken out into another layer of CDOs, with risky tiers being the first to absorb losses on the underlying CDOs and the safer tiers being insured. This multiple layering of MBSs and CDOs makes it possible to allocate risk very finely, but it also makes it very difficult to know exactly who is going to lose if any particular customer defaults on a mortgage. When this happened during the financial crisis of 2008, no one knew exactly which banks and other financial companies owned what risks because of the complexity and opacity of the layering of CDOs and related derivatives. This uncertainty undermined trust in all large financial firms.
Trading in financial markets requires that one trust one's counterparty to fulfill the terms of the trade. It you are selling something and are not sure whether the buyer will be solvent when the transaction is settled (usually in a day or two), you won't sell. When traders began to question the solvency of large banks and financial institutions in the fall of 2008, markets froze and no one was willing to trade, compromising the usual liquidity of financial markets.
Another derivative that became very popular is credit default swaps (CDSs). These are essentially insurance policies written against the default of certain entities or assets. Just as banks found MBSs useful for getting illiquid mortgage assets off their balance sheets, they used CDSs to offload the risk of other assets in their portfolio. Banks and other financial institutions (notably insurance giants such as AIG) both sold and bought insurance through CDSs, creating such a complex interconnected web of obligations that default by any major institution would trigger insurance losses by many others.
The failure of Lehman Brothers in the fall of 2008 inflicted severe losses on other financial firms through this mechanism and, once again, no one was quite sure which firms were exposed and how much, so trading froze. Had AIG or another large firm been allowed to follow Lehman into failure, it is quite possible that the entire financial system could have come toppling down.
Safety nets and rescue TARPs
"Systemic risk" occurs when the failure of one or a few institutions could cause the collapse of other major players, leading to the crash of the entire system. In previous crises, concern about systemic risk was largely limited to banks, whose interconnections through the payments-clearing system led to huge and interlinking financial obligations to one another. The 2008 financial crisis exposed another layer of systemic risk that resulted from interconnections through derivative obligations. This new kind of systemic risk involved a much larger network of financial firms, including insurance companies, investment banks, and brokerage firms.
The Federal Deposit Insurance Corporation and the Federal Reserve System have long (if not always successful) histories of monitoring and protecting the health of the payments system through regulation of banks. The spread of systemic risk to nonbank financial institutions such as Bear Stearns, Lehman Brothers, and AIG raised an immediate crisis. Because they were not banks, the Fed and other bank regulators lacked the authority to regulate, punish, or close them, or to bail them out. Through the Troubled Asset Relief Program (TARP), Congress authorized the Fed to rescue non-bank companies that posed systemic risks to the financial system. (The recently passed financial reform bill centralizes regulatory authority over financial firms in the Fed as well.) Under the authority of this program, the Fed purchased massive amounts of mortgage-backed securities from financial firms and a large ownership share in AIG. Without this rescue, it is quite possible that the financial system could have imploded, which would have devastated the entire economy by wiping out asset values and freezing the financial flows on which businesses in every sector of the economy depend. Although the initial allocation of funds to TARP was about $700 billion, recent estimates suggest that once the Fed's ownership shares in companies are sold, the actual cost to taxpayers will be closer to $50 billion or perhaps less.
This has been a short and limited introduction to some of the forces at work in the financial crisis of 2008. For more information, I strongly recommend a visit to the "Crisis & Response" information center at the Web site of the Federal Reserve Bank of San Francisco.
Questions for analysis
1. How does the availability of MBSs help the economy? How can it lead to dangerous behavior if buyers of MBSs are not fully informed? Given these benefits and costs, would you outlaw or regulate MBSs?
2. One of the characteristics of a bubble is that no one anticipates that prices can go down. How would this mentality change the behavior of home buyers? Of banks making mortgage loans? Of a financial firm buying an MBS? Of a financial firm buying a risky-tier CDO or insuring an MBS through a CDS?
3. Continuing with the previous question: What happens when the bubble bursts and prices do go down?
4. The article about Washington Mutual suggests that employees were strongly encouraged to do things that turned out to be very risky. Who gained and lost from these practices in the short run and in the long run? How did WaMu's incentive structure for employees contribute to this behavior? Would these practices have been perceived as desirable by WaMu shareholders if they had known all the details? If there are inconsistencies here, then there is a principal-agent problem at some level. Where in the chain between shareholders and employees do you think the principal-agent breakdown occurred at WaMu?